Chapter

Annex 2. Structured Debt Securities

Author(s):
Jose Cartas, and Qi He
Published Date:
June 2015
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A2.1 Structured debt securities combine features of different financial instruments. They are part of a broader group of financial instruments called structured securities. Beyond structured securities, other financial instruments may exhibit features of a structured product, such as a structured deposit combining characteristics of a deposit and a financial derivative.

A2.2 Given the many possible combinations of financial instruments, a wide range of structured securities has evolved over time. This partly explains the absence of a standard international definition for structured securities and structured debt securities. This annex fills the gap by providing broad definitions of these financial instruments. It also lists the criteria that can be used to determine whether financial instruments should be classified as debt securities and hence included in statistics on debt securities.

Definition of a Structured Security

A2.3 Broadly defined, a structured security is a security derived from, or based on, a single security or financial derivative, a basket of securities or financial derivatives, an index, a commodity, or a foreign currency.

Criteria for Structured Securities

A2.4 Five criteria for classifying structured securities, based on their main features, are as follows.

  • The degree of principal at risk. The principal may be: (1) protected and returned at maturity, regardless of the performance of the reference financial instrument; (2) exposed to losses limited to less than the full principal; (3) fully at risk subject to a level of initial loss protection; or (4) fully at risk.

  • Variation in investment returns allows six different types of structured security to be distinguished: (1) “synthetic convertible,” where the investor receives a coupon plus potential appreciation on the underlying principal; (2) “reverse convertible,” where the investor receives a coupon and is exposed to potential depreciation of the underlying principal; (3) “dynamic allocation,” where the investment is algorithmically or dynamically allocated between assets during the life of the investment; (4) “periodic capped,” where the investment return is based on the sum of periodically measured returns on the underlying principal; (5) “target return,” where the investment is terminated once a certain return on the investment has been reached, and (6) “synthetic exposure,” where there is an economically similar investment to investing directly in the underlying principal.

  • Participation characterizes whether the return is: (1) based on the initial and the final underlying levels—it does not include averaging over more than 10 percent of the term of the investment and the participation rate is fixed on the pricing date; (2) based on a periodic averaging for more than 10 percent of the term of the investment—the participation rate is fixed on the pricing date; (3) not fixed on the pricing date, but dependent on changes in the underlying principal; or (4) based on the change in the underlying principal with a ratio greater than one.

  • Type of coupon might be: (1) variable, depending on the change in the underlying principal; (2) fixed and set on the pricing date; or (3) a minimum return in excess of the principal amount and set on the pricing date.

  • Investment may be called from the investor: (1) at the issuer’s option (callable); or (2) if a predetermined movement in the underlying principal occurs (auto-callable).

A2.5Table A2.1 combines the five criteria for classifying structured securities. The degree of principal at risk criterion needs to be determined, as well as one of the remaining four criteria.

Table A2.1Features of Structured Securities
Degree of principal at risk
ProtectedPartly protectedFully at risk subject to a level of initial loss projectionFully at risk
Investment returnSynthetic convertible
Reverse convertible
Dynamic allocation
Periodic capped
Target return
Synthetic exposure
ParticipationStraight
Averaging
Variable
Enhanced
Type of couponVariable
Fixed
Minimum
Type of callCallable
Auto-callable

Definition of a Structured Debt Security

A2.6 Structured debt securities are defined as a subset of structured securities. Structured debt securities typically combine a debt security, or a basket of debt securities, with a financial derivative, or a basket of financial derivatives. These financial derivatives are typically embedded in and are therefore inseparable from the debt securities. Financial instruments in which the debt security component and financial derivative component are separable from each other should be classified as separate financial instruments.

A2.7 Debt securities with embedded financial derivatives are classified as debt securities in cases where the debt security and financial derivative components cannot be separated and the debt security is the primary characteristic (BPM6, paragraph 5.83 (d)).

A2.8 An example of a structured debt security is a credit-linked note (CLN) that combines a credit derivative and a conventional bond. Another example is a structured variable rate note (VRN), as a variation of a standard variable rate bond whose coupon payment is periodically reset by reference to an independent interest rate index such as the London interbank offered rate (LIBOR). The structured issue includes a derivative that allows the coupon calculation to be tailored to meet investors’ interest rate expectations. For example, there may be an interest rate collar or band. A third example is a VRN that has a put option for the holder to sell the issue back.

Types of Structured Debt Securities

A2.9 Using the degree of principal at risk as a primary criterion, and the type of investment return and participation as secondary criteria, four types of structured debt security can be identified. Each type is described below.

  • Principal-protected products are constructed in such a way that the capital initially invested is guaranteed from the investor’s point of view. These products offer the full downside protection of a debt security while having the upside potential of an equity security. Investors typically give up a portion of the equity security appreciation in exchange for principal protection. As such, products that usually combine a debt security with one or more options should be classified as debt securities.

  • Yield-enhanced products are designed to achieve a maximum return on investment. Accordingly, the principal is only partially protected, buffered at risk, or fully at risk. Such products offer a greater upside potential than principal-protected products but do not guarantee the full return of principal. They are partly exposed to any decline in the underlying investment below a buffer zone. Such products typically combine a debt security and a put or call option. They should be classified as debt securities.

  • Participation products derive their value from different types of security. Depending on the underlying securities, these products should be classified as debt securities, equity securities, or investment fund shares or units.

  • Leveraged products with a large risk compared with the initial investment combine an investment in an underlying security with a future or option. Even if the initial investment is small compared with the expected risk, leverage products should be classified as debt securities.

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